Capital and risk in Italian banks: A simultaneous equation approach
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Capital and risk in Italian banks: A simultaneous equation approach Francesco Cannata and Mario Quagliariello
Banca d’Italia, Banking and Financial Supervision, Via Milano, 53-00184 Rome, Italy fax: þ 39 0647925059; e-mail: [email protected]
Francesco Cannata is an Economist, Bank of Italy and Banking and Financial Supervision. He is an expert of credit risk management, prudential regulation and Basel II capital Accord. Mario Quagliariello is an Economist, Bank of Italy, Banking and Financial Supervision. He is also an expert of financial stability, macroprudential analysis and prudential regulation.
ABSTRACT
We analyse banks’ decisions regarding the optimal levels of capital and risk. Following previous research, we apply the simultaneous equation approach and the partial adjustment framework proposed by Shrieves and Dahl on Italian intermediaries over the period 1994–2003. Our results confirm that banks determine capital and risk levels simultaneously in order to meet regulatory capital constraints. However, there are significant differences across intermediaries depending on their starting capital levels. Regulatory pressure seems to push poorly capitalised banks to adjust capital levels to a larger extent and more rapidly than the others when risk changes; moreover, less capitalised intermediaries react to capital increases by reducing risk exposures in order to restore proper capital cushions. Journal of Banking Regulation (2006) 7, 283–297. doi:10.1057/palgrave.jbr.2350029
INTRODUCTION For the last two decades, supervisory authorities of major countries have been relying on
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the ability of banks to meet minimum capital requirements in order to assess their soundness. In July 1988, the Basel Committee for Banking Supervision harmonised capital standards across G10 countries, establishing that internationally active banks have to hold an amount of capital not lower than 8 per cent of their riskweighted assets. Such a rule has eventually been accepted by more than 100 countries worldwide. Following the European implementation, the regulation on capital adequacy came into force in Italy in 1993, although banks had been already asked by Italian supervisors to meet a certain proportion between capital and risky assets.1 The 1988 Capital Accord has been recently revised. In June 2004 the Basel Committee issued a new framework for assessing the capital adequacy of banks, which will come into force at the end of 2006. The new Accord, though more articulated, does not substantially modify the spirit of the current discipline. Banks will be asked to hold capital resources equal to a certain percentage of the risk implied in their portfolios; what is different with respect to the 1988 Accord is the range of methodologies that intermediaries will be asked to choose to calculate the capital requirements for credit and operational risks. Beyond the regulatory action, the importance of capital has gradually increased for Italian banks in recent years
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